Advisors Reveal Top Tips For Stock Options, RSUs, ESPPs

Equity awards are complex, and so is the financial planning. No single strategy fits all. You must link the necessary financial and tax decisions to your own personal situation and goals. However, there are some general financial-planning considerations to understand before you start. A recent myStockOptions webinar featured four leading advisors who routinely work with clients that have equity comp and company stock acquired from their grants. In the real-world case studies they presented, they discussed their core strategies for stock options, RSUs, ESPPs, and company shares.

Start With Your Personal Goals

All of the advisors who spoke in the webinar cited the complexity and highly personal nature of planning for equity compensation and company stock holdings. “I always start with clients by asserting that these are complex benefits,” said panelist Megan Gorman, the founder of Chequers Financial Management in San Francisco and the author of a highly anticipated forthcoming book, All The Presidents’ Money. Megan emphasizes the importance of “playing the long game” with her clients. “We have to keep them on strategy, and strategies are personal—ignore the watercooler talk.”

“I also start with the client’s personal and financial goals,” stated panelist Chloé Moore, the founder of her firm Financial Staples in Atlanta. “What are they wanting to accomplish in the short term and in the long term? What are their cash needs? What do they want their life to look like and how can we use these RSUs or other equity awards as a tool to help make those dreams reality?”

Equity Comp As Goal Accelerator

Chloé said she often frames this as “accelerating that timeline.” For retirement goals, the stock-sale proceeds can perhaps go toward saving more, investing more, and making retirement possible sooner. For short-term goals such as buying a house or paying off student loans, the proceeds from equity awards can bring those goals even closer to the present.

An important point that Chloé stressed is that you should “live off your base salary and not rely on occasional income from equity awards or bonuses to fund basic living expenses.” Stock compensation “is really something that clients need to achieve or accelerate financial goals,” she reiterated.

Be Realistic With Yourself

Danika Waddell, the founder of Xena Financial Planning in Seattle, raised the importance of personal comfort level and pragmatism in financial planning for equity comp and company shares. “I think it’s really important to keep in mind that even though there may be an optimal financial or tax strategy, it may not make sense for the client—whether they’re not comfortable with it or it’s too complicated or for whatever reason they are just not willing to do that strategy. You have to find something that’s going to work for that client.”

She pointed out that, oddly enough, the strategies which actually work for her clients are often not the ones that are optimal from a tax perspective or a financial perspective. They are successful, she emphasized, because the client will stick to them.

“Tune out the noise,” added Danika. It’s vital, she asserted, to craft and stick with a financial plan that is tailored for you, regardless of casual advice from those around you. “Almost all of my clients hear a lot of opinions from co-workers and on Slack channels. They may also be getting input from an uncle, a dad, a cousin. What I say to clients is that they may be smart people and know a lot about tax situations, they don’t know everything about your situation. They may be at a different life stage. They may be in a different tax bracket.”

Know How Much Tax Will Be Withheld

For most employees, 22% is the statutory federal withholding rate for supplemental wage income, such as income recognized from stock option exercises or RSU vesting, and it’s the rate that most companies use. (The required withholding rate rises to 37% for amounts in excess of $1 million during the calendar year.) Depending on your overall yearly income and tax bracket, the 22% withholding rate may not be enough to cover the taxes you actually owe according to your bracket rate.

“A lot of my clients’ companies now give employees the chance to add extra withholding on top of the 22%, so they can choose exactly the amount of withholding they want,” observed Chloé Moore. “If that’s a choice and it makes sense for the client, we’ll get that as well. If not, we’ll want to be sure they set aside cash to cover the tax bill.”

Quarterly estimated tax payments are one way to cover any shortfall in the tax withholding. Alternatively, you can put cash aside from stock-sale proceeds to pay the taxes with your tax return for the year.

Sell The Company Shares Or Hold Them?

This is the $100,000 question (or maybe even more). When you receive shares of your company’s stock via equity compensation, whether you sell or hold the shares depends on various factors. Some of those factors, especially personal ones, are under your control, while others stem from the tax rules, your company’s stock plan, or its blackout periods for insider-trading prevention. Nevertheless, many advisors often suggest immediately selling all or most of the shares received at RSU vesting, chiefly to diversify and thus avoid the risky overconcentration of your wealth in just the stock of your company.

Webinar panelist Daniel Zajac, the managing partner of Zajac Group in the Philadelphia area, often takes this approach. “Generally speaking, selling RSU shares right when they vest is where we lean with most of our clients, and then we figure out what to do with the proceeds,” he explained. “Are we going to cover taxes by putting money on the side, making estimated tax payments, running tax projections? Or are we going to take the rest of it and invest it, fund a goal, buy a house, doing whatever the client wants to do with that excess money.”

Diversification

Danika Waddell concurred—and pointed out the importance of diversifying. “This isn’t a blanket rule, but for many of my clients I recommend selling RSU shares soon as they vest and setting aside money for the taxes and just diversifying,” she said. “Many of the clients I work with come to me with already 60%, 70%, 80% of their net worth tied up in their company stock, so we’re absolutely working on diversification. If that’s not the case, it’s a little less critical. But for many people it’s just sell as soon as the shares vest.”

Danika recommends this course of action even more strongly for shares acquired via an employee stock purchase plan (ESPP). “If someone is going to participate in an ESPP, I always recommend selling the ESPP shares as soon as they become available. I don’t really want anybody to hold on to them. I’ve seen too many situations where it doesn’t pan out, and then the ESPP taxes are just so complex on top of that.”

Automate Selling Under Your Plan Where Possible

Automated selling is another recommendation that Danika favors. “I’m a big fan of automation. If your company allows you to set things to auto-sell, that leaves one less thing on your plate. Especially if your RSUs are vesting monthly, you otherwise have to go in and remember to sell shares.”

Daniel Zajac agreed. “As much as we can automate selling for clients, we’re all for it. It’s not uncommon for our clients to come in regularly with $50,000 or $100,000 of after-tax RSU money that’s been sold, and we then dump it into an investment account, where it builds and builds. And clients start to love that action, seeing that account get bigger and bigger over time.”

Danika noted that dispassionate automated selling can work well as part of a financial plan determined in advance, sometimes in the form of a Rule 10b5-1 trading plan if you frequently know material nonpublic information about your company. “Make it really simple so that you’re not constantly having to think about when should I sell, how should I sell, what should I wait for—removing as much as possible emotional decisions.”

Capital Gains Tax

What about the tax on capital gains when you sell shares? Avoid letting aversion to capital gains tax get in the way of your bigger-picture financial planning. “Don’t let the tax tail wag the planning dog,” quipped Megan Gorman. “I think it’s great that sometimes people focus on the tax, but sometimes you just have to sell. You pay the tax and you move on.”

Further Resources

The webinar in which these advisors spoke is available on demand at the myStockOptions Webinar Channel. It is part of our Equity Comp Masterclass series of three webinars. For additional guidance and ideas, see the extensive resources in the section Financial Planning at myStockOptions.com, along with the website’s modeling tools and calculators for stock options, restricted stock, and restricted stock units.

SPECIAL WEBINAR

Equity Comp Financial Planning For Private Company Employees: From Startup To IPO Or Acquisition

Wednesday, Sept. 11 (2pm–3:40pm ET, 11am–12:40pm PT). See the webinar registration page for a detailed agenda. 2.0 CE hours for CFP, CPWA/CIMA, CEP, CPE, and EA

Join us for this lively webinar on financial and tax planning for equity comp and shares in private companies. In 100 minutes, a panel of leading financial and tax advisors will present practical insights and real-world case studies:

• Alfred Au (MS, CFP®), DiversiFi Capital
• Meredith Johnson (CPA, CFP®), BPM
• Kristin McKenna (CFP®), Darrow Wealth Management

Decreasing valuations for private company stock, the growth of private company liquidity programs, and the slowdown in IPOs make the need for effective guidance even more important, as this webinar covers.

Register now. Time/date conflict? No problem! All registrants get the webinar recording, slide deck, and handouts.

Stock Options Lost In Job Termination: How One Fired Employee Won Big

Job termination is a major event not only for you but for any stock options you have. It's important to know your post-termination exercise period (PTEP), which is specified in your grant agreement. The PTEP dictates how much time you have to exercise vested stock options after job loss. Typically, you have just three months to exercise vested options, and you forfeit any unexercised options.

However, all bets are off if you’re fired “for cause,” i.e. the company ends your employment due to your bad behavior. In that case, usually your stock options, included vested options, expire immediately on your termination date. That can cause you to miss out on a big stock option payday.

Stock options are potentially very valuable, especially when they are granted in a startup company that later undergoes an initial public offering (IPO). Inevitably, with great potential wealth comes great litigation. Case law abounds with disputes between former employees and companies over valuable stock options. While companies often prevail in such litigation, a recent lawsuit over startup company stock options in California, Shah v. Skillz Inc., resulted in a lucrative win for the plaintiff (a fired employee) and a notable ruling about how damages involving options can be calculated.

Gaming Company Employee Does Not Play Games After Firing

Gautam Shah, the plaintiff, worked at Skillz Inc., a company that makes games for mobile phones. He joined Skillz in 2015, when it was a private company in San Francisco, and received a grant of stock options. Like many startup companies, which may have little cash, Skillz relied heavily on stock options and other equity awards to reward employees in lieu of cash compensation. As a private company’s stock lacks liquidity, a startup company’s employees with stock options hope that their options will become valuable after the company goes public or is acquired.

In 2018, Mr. Shah told the two founders of Skillz that unless he received a promotion and a raise, he would consider leaving the company. In the circumstances, the founders suspected he might have done something to undermine the company’s interests. A company forensic analysis revealed that Mr. Shah had forwarded a highly confidential business report to his personal email address, apparently for no legitimate business reason. He was fired “for cause” on the grounds of a breach of his employment contract via a purported violation of company policy about confidential information and theft.

Not surprisingly, at the time of his firing Mr. Shah tried to exercise some of his stock options. However, he was told the options were immediately void because of his “for cause” termination, as provided under his stock option agreement. Mr. Shah claimed he had forwarded the document to himself purely for convenience and was not in breach of contract, to no avail.

In late 2020, Skillz went public via an IPO. Several Skillz employees, both current and former, profited handsomely from shares they held in the company. In 2021, Mr. Shah sued Skillz for breach of contract, wrongful termination, and retaliation. He claimed that Skillz did not have cause to fire him and had therefore wrongfully prevented him from exercising the stock options he had earned as a Skillz employee.

In the trial, the jury awarded Mr. Shah more than $11.5 million in damages for his lost options, finding by implication that he had not been legitimately fired for cause. The jury was evidently unpersuaded that Mr. Shah’s forwarding of the email to his personal address was done in bad faith. In other words, it decided that the basis of the firing arrived at by the company was an unfounded miscalculation.

Company Miscalculation Leads To Big Calculation Of Damages

Crucially, the jury calculated the monetary value of Mr. Shah’s damages according to what his shares would have been worth after the IPO had he been allowed to exercise his options then. The figure they arrived at, over $11.5 million, made a fine payday for Mr. Shah. If the damages had been calculated on his options’ value at the time of his firing, they would have amounted to a paltry $41,032.

Skillz appealed, arguing that the monetary value of the damages should be assessed according to the option value at the time when Mr. Shah was fired. However, the California Court of Appeal held that, under both California and Delaware law, damages for lost stock options in a breach-of-contract action can in certain circumstances be assessed from a date other than the date of the breach.

Those circumstances include the availability of a market for the stock at the time of the contract breach. When Mr. Shah was fired in 2018, Skillz was still private, so its stock had no liquidity. On that reasoning, the court upheld the decision to calculate the damages for lost stock options using the shares’ value after the IPO, though it did reduce the damages to $6.7 million.

The court also ruled that stock options are not “wages” under the California Labor Code. This meant that, while his breach-of-contract claim was successful, Mr. Shah’s claims for retaliation and wrongful termination were dismissed. He therefore lost any right to pursue tort damages, which could have included punitive damages and attorney’s fees. Interestingly, the court noted that restricted stock would be considered “wages” because, unlike options, they have an “ascertainable value.”

Lessons For Companies And Employees

To avoid costly lawsuits, companies often consider future vesting dates when terminating employees. The actions they take may delay the termination date, extend it by using “paid time off” days, or accelerate the upcoming vesting to avoid appearing to terminate an employee merely to forfeit soon-to-be vested equity grants. If a company plans to terminate your employment for what you believe are unjustifiable reasons, you can also negotiate with it to take actions such as those so that you avoid losing valuable stock options or restricted stock units (RSUs).

Attorneys at the law firm Squire Patton Boggs cover additional employer implications of Shah v. Skillz in a commentary for the firm’s blog Employment Law Worldview. The attorneys conclude that in similar situations companies should “proceed with caution” when firing employees for cause.

Additional Resources

For more on job termination when you have stock options and RSUs, see a related blogpost, Job Loss: How To Protect Your Stock Options And RSUs. See also the Job Events section on myStockOptions.com, including a fun interactive quiz.

myStockOptions Webinars

See the myStockOptions Webinar Channel for upcoming webinars and past webinars on demand. Each webinar offers CE credits for CFP, CPWA/CIMA, CEP, EA (live webinars only), and CPE (live webinars only), plus CFA self-determined credits. Featured experts present real-world case studies. On-demand webinars are listed below. Click on the links to register now!

FUNDAMENTALS

• Equity Comp Masterclass (Part 1): Stock Options

• Equity Comp Masterclass (Part 2): Restricted Stock/RSUs & ESPPs

• Stock Compensation Bootcamp For Financial Advisors

• Stock Comp Tax Essentials: Crash Course

ADVANCED

• Equity Comp Masterclass (Part 3): Best Ideas From Top Advisors

• Restricted Stock & RSU Financial Planning: Insights From Leading Advisors

• Stock Option Exercise Strategies: Managing Risk & Building Wealth

• Year-End Financial & Tax Planning For Equity Comp

• Preventing Tax-Return Mistakes With Stock Comp & Stock Sales

SPECIALIZED

• Stock Comp Financial Planning For Private Company Employees: From Startup To IPO Or Acquisition

• 10b5-1 Trading Plans And Other SEC Rules Advisors Must Know

• Strategies For Concentrated Positions In Company Stock

• Negotiating Equity Comp At Hire & Protecting It In Job Termination

IRS Audits Of Equity Comp: New IRS Guide Shows What To Expect

An IRS audit: a prospect that provokes stress and anxiety. Even if you are not personally targeted for an audit, an IRS audit of your company's equity compensation can still put you on the hook. Depending on what IRS examiners find, a company audit can lead to individual audits and amended personal tax returns for executives and employees.

The IRS recently surprised tax experts by issuing a new version of its stock compensation auditing guide, which had not been updated since 2015. Developed as an internal manual for IRS employees, it also offers businesses a helpful window into what IRS agents examine in audits related to all types of equity compensation. It’s a heads-up on stock options, restricted stock, restricted stock units (RSUs), stock appreciation rights (SARs), phantom stock, and employee stock purchase plans (ESPPs) for anyone who has these benefits or advises clients with them.

Professionals and taxpayers alike should review the guide to avoid pitfalls and tax situations that could trigger a dreaded IRS audit—the worst of which has been vividly described by tax attorneys as “an autopsy without the benefit of death.”

What IRS Agents Inspect With Stock Options And ESPPs

The IRS manual is called the Equity (Stock) - Based Compensation Audit Technique Guide. It gives IRS examiners a roadmap for audit scrutiny into when income should have been recognized, reported, and subjected to withholding, along with the related records, documents, and terms to review. In some ways, it also provides a brief general review and summary of equity comp taxation and IRS interpretations of the Internal Revenue Code (IRC).

As publishers who takes pride in the clear plain-English explanations of tax rules offered on myStockOptions.com, we could quibble with the IRS-speak and some inaccurate interpretations of the IRC in the audit guide. However, for now, let us simply highlight some issues the guide instructs IRS examiners to focus on in their search for tax errors:

• Loans to exercise options to ensure that they are recourse loans (i.e. you personally pay should you default) and whether they were forgiven/canceled or reduced.
• Qualifying and disqualifying dispositions for incentive stock options (ISOs) and tax-qualified ESPPs. These are shares from ISO exercises or ESPP purchases that were sold either before or after the statutory holding periods of two years from grant and one year from exercise/purchase that provide the best tax treatment.
• Annual limits on the size of ISO grants (only $100,000 can be vesting/first exercisable in one year) and ESPP purchases ($25,000 annual limit). While your company probably has a stock plan administration program to help it adhere to these limits (which are not adjusted for inflation), company mistakes can change your tax treatment by turning your ISO grant and ESPP into nonqualified stock options.
• Restrictions on transferred stock that create a substantial risk of forfeiture (SRF) which needs to lapse before taxes apply. The SRF concept is standard, for example, with most grants of restricted stock or RSUs, which must vest before you recognize taxable income and could be forfeited if you were to leave the company before the vesting date. A stock buyback right for your company at job termination is not seen by the audit guide as an SRF that postpones income recognition, as it defines those as “non-lapse restrictions.”
• Transfer of stock options to related persons, which makes them a “listed transaction” and could be an abusive tax shelter.
• Company reporting requirements for your ISO exercises (on Form 3921) and ESPP purchases (on Form 3922).
• Form W-2 reporting, including special reporting and codes for nonqualified stock options and other grants.
• Appropriate amounts and timely deposits of withholding for federal income tax, FICA (Social Security and Medicare), and FUTA.
• Timely IRC Section 83(b) elections for the early-exercise stock options used by private companies. Also for startups, whether any elections were made under IRC Section 83(i) to defer income.

IRS Collection Efforts Have Intensified, Including Audits

The updated audit guide also reflects the ways in which the IRS directs more audit attention toward higher-income taxpayers. The IRS has intensified its efforts in that area during recent years.

In 2023, the IRS announced a special focus on ensuring that large corporations and rich individual taxpayers pay taxes owed. In particular, the IRS said it is “ramping up efforts” to pursue high-income, high-wealth individuals who have not paid their taxes. The agency is concentrating in particular on roughly 1,600 US taxpayers with more than $1 million in annual income and over $250,000 in federal tax debt. Simultaneously, the IRS reassured middle-class taxpayers that audit rates would not increase for yearly incomes of under $400,000.

The initiative to collect past-due taxes from delinquent millionaires has paid off significantly. In early 2024, the IRS revealed that it had recovered more than $482 million in previously unpaid taxes. Just this month, the IRS reported that it had collected over $1 billion in past-due taxes from the target group. The agency stated that the revenue to that point represented payments from over 1,200 of the 1,600 targeted millionaires.

These efforts are funded by the $80 billion in additional multi-year funding that the IRS received under the 2022 Inflation Reduction Act. The agency wants to reduce the embarrassingly wide $688 billion gap between estimates of the amount of tax owed each year and the amount that is voluntarily paid.

Likelihood Of Getting Audited: Data On IRS Audit Activity

In general, the more you make, the more likely you are to be audited by the IRS. Sudden income spikes, such as income from a stock option exercise or the vesting of RSUs, are a red flag that can trigger an audit.

The IRS periodically publishes information about its general audit activity. The latest update, the 2023 IRS Data Book, covers the IRS fiscal year from October 1, 2022, through September 30, 2023. It reveals the following facts:

• Over the decade preceding 2023, the IRS examined tax returns filed by 8.7% of taxpayers with income of more than $10 million; 3.1% of taxpayers with income of $5–10 million; and 1.6% of those with income of $1–5 million.
• In 2023, the IRS completed 582,944 tax-return audits, resulting in nearly $32 billion of extra tax revenue.
• Most audits in 2023 (77.3%) were conducted via correspondence; 22.7% were conducted “in the field.”

Increasingly, IRS computers automatically check tax-return accuracy. The Automated Underreporter Program compares income in tax returns with IRS data. When the computers find a discrepancy, they automatically issue a notice (CP-2000) requesting an explanation.

CP-2000 Notice For Not Reporting Company Stock Sales Accurately

For example, when you immediately sell all shares acquired from a vesting of restricted stock or exercise of stock options, you may think you do not have taxable income beyond the ordinary income reported on your W-2, as there was no capital gain upon the stock sale. However, even in this situation, you must report the stock sale on IRS Form 8949 and Schedule D of your Form 1040 tax return, as the IRS still receives Form 1099-B from your brokerage firm to report the sale. If the sale is not also reported on your IRS forms, the IRS will send you a CP-2000 notice looking for you to pay taxes on the full amount of the sale proceeds!

Additional Tax Resources

For additional tax resources on all types of equity compensation and ESPPs, including tax-return reporting, see the Tax Center on myStockOptions.com.

myStockOptions Webinars

See the myStockOptions Webinar Channel for upcoming webinars and past webinars on demand. Each webinar offers CE credits for CFP, CPWA/CIMA, CEP, EA (live webinars only), and CPE (live webinars only), plus CFA self-determined credits. Featured experts present real-world case studies. On-demand webinars are listed below. Click on the links to register now!

FUNDAMENTALS

• Equity Comp Masterclass (Part 1): Stock Options

• Equity Comp Masterclass (Part 2): Restricted Stock/RSUs & ESPPs

• Stock Compensation Bootcamp For Financial Advisors

• Stock Comp Tax Essentials: Crash Course

ADVANCED

• Equity Comp Masterclass (Part 3): Best Ideas From Top Advisors

• Restricted Stock & RSU Financial Planning: Insights From Leading Advisors

• Stock Option Exercise Strategies: Managing Risk & Building Wealth

• Year-End Financial & Tax Planning For Equity Comp

• Preventing Tax-Return Mistakes With Stock Comp & Stock Sales

SPECIALIZED

• Stock Comp Financial Planning For Private Company Employees: From Startup To IPO Or Acquisition

• 10b5-1 Trading Plans And Other SEC Rules Advisors Must Know

• Strategies For Concentrated Positions In Company Stock

• Negotiating Equity Comp At Hire & Protecting It In Job Termination